Wednesday, 26 November 2008

Some lessons from Economic Theory 101

As the details begin to come in about the various programs worldwide to help the economies going again after the hitting the concrete wall in September and October, it may be worth taking a look at some of the fundamentals.

For beginners, this crisis does not have its root in exotic financial products, difficult to understand and totally intransparent. Those products only allowed an underlying problem to continue for way too long, namely a "debt inflation". By this I mean that too many economic players in several countries had indebted themselves beyond reason. In times of old – two decades ago – the banking system would have stopped them from doing so somewhat earlier. But this time the banking system had invented products that allowed them to believe that the risks were so effectively diversified that the lending could go on forever. We now know it was not true. And we are up that creek, seemingly without a paddle.

We are now facing a debt overhang of alarming proportions. There are a number of ways out. One is known by everybody who has ever owed a little too much money away – you cut back and live within your means until the situation is mended. For entire economies there is another way out, namely inflating until the real value of the debt has been reduced to manageable proportions. And then there is the tough one, defaulting on the debt. Which is a good deal more difficult for a country to handle than for individuals. We will look at the first one here, as that is the one currently being discussed in the market.

The first solution, to cut back on one's standard of living is exactly what we are looking at now. The traditional recipes – usually dished out to Third World Countries by the IMF – consists in a combination of policies that aim to reduce the standard of living of the households and to boost the exports. This will invariably entail a period of slow or negative growth in private consumption while the savings balances are re-established. This time it is not the IMF who to the tune of a chorus of assorted leftist protests imposes strict conditions. It is the developed economies themselves that are reacting against years of excess.

Whereas the US and the UK undoubtedly are leading the pack in terms of household sector indebtedness, there are many other countries who to some degree are suffering under the same problems. And the world is heading into a rapid and deep recession because consumers are beginning to get very scared and are cutting back on the consumption. This situation is then amplified by a seriously handicapped banking system which has stopped lending despite hefty dollops of state subsidies.

Lesson Number One is thus that we have a recession coming on because it is necessary in order to correct a huge debt overhang.

Now everybody is looking to the governments for help to "kickstart" the economies. UK's Chancellor Alistair Darling presented a package yesterday. US Treasury Secretary Paulson began talking about an additional $800bn of public money on top of the $700bn or $950bn already being doled out to the banking sector. In Europe it appears to be more difficult to arrive at some kind of agreement. France's president Sarkozy has been leaning on Germany's Chancellor Merkel for Germany to take the lead in pulling Europe out of the quagmire. The EU Commission has had to limit itself to call on the Member States to do something and has suggested fiddling with the VAT rates. But so far we are months away from really detailed programs (UK being the exception, probably because PM Brown himself is a former Chancellor of the Exchequer and hence as a grasp of the details. Plus an absolute majority in parliament).

Currently, the game is about guessing "how much" will be needed by way of stimulus. The counterquestion could be "in order to obtain what?" Globally , we are in totally uncharted waters. A severe recession is on its way. So do we want to avoid the recession entirely as some of the players in the stock markets appear to believe with their continued optimistic earnings estimates for 2009 and 2010?

I am afraid that it is not possible. The scale of the debt overhang in the US alone is astronomical enough that it will be a while for them to sort out the mess stateside. And given the weight of the US economy worldwide, this alone will work as a drag on the world economy. Then add the other countries where a property boom has helped to undermine savings. Some of the more thoughtful commentators and analysts appear to agree that the US economy alone could shrink by 5-7 percent in order to impose a sufficiently deep reduction in living standards. While this being a piece of back-of-the-envelope calculation, it goes well with other studies over the past five years addressing the possibilities of redressing the international imbalances.

It appears that what we can hope for is to cushion the blow of the recession, keep the banking system afloat and try to learn from past mistakes. But Lesson Number Two is that nothing can be done now to avoid a recession. We can only hope for its effects to be dampened.

Which leads us to the third issue, namely how to spend the gazillions of dollars/euros/yen now about to be handed out. I am afraid that we have to go back to Macroeconomics 101. Again. Even to those who had hoped that Keynes was well and truly dead, one only needs to mention the word liquidity trap in order to explain the situation. It has been popping up more and more frequently in the past three weeks: for all the help granted to the banking sector, nothing has managed to stimulate lending. We are in a situation where further easing of monetary policy will not work. The details are different from what Keynes explained, but the result is the same. Billions will yet be spent on underpinning the financial system, but will have no effect on getting the economy moving again. In order to obtain that, one has to look to the same elements as in the '30s: Demand.

There is no shortage in Europe of suggestions of temporary VAT reductions. In the US the talk is about temporary income tax reductions. But hey, have a look at the consumer, now understanding that he has bought a family home too expensive for his salary, and his job becoming more and more likely to go out the window as the recession progresses. He is unlikely to spend any windfalls from tax relief of one sort or another on consumption. He will use every penny to reduce his debts. This behaviour is fully in line with one of the more deep-seated theories of consumer behaviour, namely the permanent-income hypothesis, developed by one Milton Friedman in the '50s. It briefly states that consumers will base their consumption on what they believe to be their long-term income and save any windfall gains. Such as temporary tax reliefs...

Over the past three decades, it has become more and more Conventional Wisdom that state-run expenditure programmes should be avoided. No more New Deals to mess with the profit incentive structure in a well-functioning capitalist economy. But we do not have a well-functioning economy at this moment in time. A long, ideologically based foray into deregulation caused us to fall off that road. So the Third Lesson we can derive from basic economic theory is that public sector demand probably will be necessary in order to stimulate the economy.

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